Heather Langsner is the new director of Sustainability Research at risk management provider Riskmetrics Group. She talks here about the potentially “disruptive” power of sustainable investment analysis and her passionate belief that this kind of research is poised to transform the practice of equity valuation.
Langsner comes to Riskmetrics from Innovest, a company that applies both qualitative and quantitative environmental, social, and governance risk analysis methodologies to uncover investment value. Riskmetrics acquired Innovest in March 2009.
Sustainable investing means many things to many people. How do you define it?
The old term “socially responsible investing” is really just a catchall phrase to encompass many types of investment themes. Historically, it has been associated with the practice of negative screening which eliminates stocks from portfolios on the basis of a values issue such as alcohol or tobacco, for example. However, now we use the term sustainability research and, in a more modern interpretation of the field, it means taking into consideration all drivers of financial performance, even those things that don’t necessarily show up in the balance sheet and income statement. It means that all companies and sectors face a variety of risks and opportunities not revealed in conventional equities research that must be evaluated to form a more comprehensive view of the long-term value of equities (and other asset classes). This allows you to have better risk-adjusted returns across a wide, investible set of companies without regard to judgments about sectors.
What drives your interest in sustainable investment analysis?
I have this personal mission to change the way sustainability analysis has been regarded as somehow a soft area, that doesn’t add value. In fact it is serious and rigorous and uncovers tremendous value when it is done right. I guess I could have gone to work for an NGO but I felt that if I really wanted to make a difference, well, it was the financial markets that drive change.
What, in your opinion, are the major factors behind the growth in sustainable investing?
There are a number of factors that are driving this. Just to bring up a few things, there was the European Union directive implemented in the late nineties requiring public pension funds to state whether or not they are incorporating sustainability analysis into decisions. Sarbanes Oxley also requires companies to disclose a certain amount of environmental information in their legal proceedings.
In my view, Goldman Sachs was driving it partly because of the environmental focus of their former leader Hank Paulson. He got it that this is where markets were going and perhaps this might be part of company’s sell-side message. Without being too loud about it, Goldman was integrating environmental concepts into its everyday actions. Simultaneously, I noticed companies like GE making this part of their top line growth message. Previously everyone looked at sustainability as some sort of charity thing, like organizing a clean-up day at your company.
Then I think things like the Carbon Disclosure Project has had an impact where you are talking about a huge number of institutional investors getting together and saying, “This is part of our responsibility to understand how companies are dealing with this sustainability issue.”
The financial markets are slowly recognizing that if you don’t incorporate this so-called soft information into your analysis of companies and fixed asset classes you are missing parts of the analysis that could come up and bite you hard later.
What is Riskmetrics’ approach to sustainable analysis and how does it differ from mainstream analysis?
RiskMetrics rises out of this new mentality, we say we are not doing sustainability to be nice; it is part of an analyst’s fiduciary responsibility to address these issues. In the past it was “I am only responsible for looking at the income statement and balance sheet.” But we demonstrated with companies like Tyco and others that it was the things that don’t show up on the balance sheet that were the problem. You have to have some way to analyze what is going on behind the financial statements; you have to see these intangibles as critical to long-term investment. There are many things like the way a company deals with human capital or supply chain issues for example that determine its competitive value in the market. And by focusing an environmental and social lens on these issues you get a new perspective on management quality—a key determinant of long-term performance of companies.
We take the view that how management deals with various sustainability drivers—like climate change regulation, constraints on water and energy resources, changing population dynamics, and changing market demand for less toxic, more sustainable products—are good tests for determining value. When you dig into these so-called soft issues you get a lot of information. We are saying to the market we believe a lot of the sustainability issues are moving from being purely values-oriented issues where investors are saying ‘I don’t like to invest in alcohol and tobacco companies’ to moving into an era where there is a good business case for looking at things like climate regulation and water scarcity and trying to use traceable data to determine if there are potentially material concerns for companies.
Climate change and carbon emissions are a good example. In the late 90s people were just starting to look at them but over time as you can see there are 13 states that have regional regulation for utilities. There is deep regulation in certain markets depending on where you have operations. Increasingly we are looking at a cap and trade system in the U.S. so it has now moved into the realm of being business relevant and having traceable data. Through our equities valuation techniques we are able to express the impact on a percent of earnings and present value basis.
We are also analyzing those factors at that intersection where an issue starts out being “soft,” but is moving into being business relevant. The idea is to be at the beginning of those stages, and tracking and managing and monitoring company performance as some of these criteria move into being something material and traceable. Like water risk, there isn’t good data right now but that won’t last forever.
Sometimes we are diverging from the Street. If you look at our time series and look at the changes over time from year to year you begin to see we are doing something very different from what the Street is doing. We are using different information in the portfolio management process.
We diverge from Wall Street on a sector basis almost completely. Our ranking of the chemical sector diverges significantly from conventional consensus, for instance. In the early 2000s the chemical sector was largely regarded by the conventional analysts as being a dead sector. Very mature, no top line growth and in fact material prices were killing it. We were saying at that time, we actually see a whole lot of top line growth in this sector. In fact we were starting to predict M&A activity based on clean technology and green chemistry concepts. We turned out to be correct in a general sense and more specifically, that analysis allowed us to be predictive for example about things like BASF acquiring Engelhard; we were evaluating the two company’s green chemistry portfolios. I feel that has always been our focus and purview even when it wasn’t considered pertinent to do so. It is a downside and also an upside picture we look at. Even if a company is deeply exposed to a risk factor if it is turning it into an opportunity through something like clean technology that can totally alter the picture.
What are the biggest challenges for sustainability analysis?
I think the most significant challenge is the current idea that all you have to do is just gather all kinds of data that may in some way relate to sustainability, crunch the numbers, and you will get a reading on companies that will do something for your portfolio. I am not opposed to data, but to me it has to be done right and there has to be qualitative analysis. You can’t just automate something like this, it is not like following GAAP issues, it is a new field, and there is no standard. To understand companies’ values through a sustainability lens you need to actually dig in and assess them on a company-by-company basis. At some point the data has to be used in a rigorous analytical way. There has to be a human behind it with expertise and insight.
Also the whole concept that each industry has its own sustainability drivers has to be recognized. You can’t compare the same two issues in the mining and the banking sector, they are different. You can’t standardize it across sectors.
Also the challenge is to figure out how to make sustainable investment analysis relevant to investors and help them understand and use it in a way that enhances their portfolio management process. So someone who is agnostic about the content of the information—for example, who has no opinion about climate change—can still use our data to enhance portfolio performance. For example, our data is non-correlated with general market performance and by monitoring the changes between our ratings from year to year you can pick up some interesting momentum information about companies and sectors.
What do you see as the synergies between Riskmetrics and Innovest?
We think we will change markets and how companies are valued by combining Riskmetrics track record in financial risk analysis, forensic accounting and governance with Innovest’s sustainability investing expertise. With our combined expertise we feel confident we can provide financially relevant and material analysis on sustainability using conventional equities valuation techniques that portfolio managers understand. Moreover, we can do it for a universe of 2000 companies. I feel I am sitting here at the beginning of something very big that will be industry defining.
What will sustainability analysis look like in ten years?
I think ten years out incorporating sustainability factors will just be a part of doing mainstream equities analysis. It won’t be considered a sidepiece. It will be applied to different asset classes like fixed income.
Also in ten years, it will be more generally acknowledged that the corporate social responsibility report is only a starting point for sustainability analysis. At RiskMetrics, we are trying to dig much deeper than a CSR report would go. Companies are often surprised by the nature of our questions and how fundamental they are. We end up finding out ourselves where the company’s reportage is right or not. Sustainability analysts do know how to do math! Companies think we are the soft analysts and they are surprised to find we have verified what they put in the CSR report and we often disagree with it.